Generally the international traders need help of financial intermediaries like banks for guaranteeing payments and also the assurance of delivering goods on time. Letters of credit usually accomplish their goal by playing the role of a substitute to the credit of the bank to that of the client mainly for facilitating trade. Such a letter is issued by a bank to guarantee full payment and timely payment to the seller. Under a circumstance where the buyer is not able to make such a payment, the bank will either cover the entire amount or the remaining amount on the buyer’s behalf. This letter is granted against a pledge of cash or securities as collateral. Banks also collect a fee which is a percentage of the total amount of letter of credit.
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| Letter of Credit |
Letters of Credit - Their importance
International trade comprise of factors like different laws, distance, various laws pertaining to the countries involved and the dearth of contact during the process of trade. Amidst all this, letters of credit are used as a dependable mechanism of payment. The letters of credit that are used during international transactions are supervised by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits.
Key elements of Letters of Credit
The issuing bank gives a payment undertaking
On the buyer’s behalf who is also the applicant
To pay off a beneficiary (mostly a seller) for a specific money amount
On providing the exact documents that are proof of the goods supply
Within a stipulated time period
Documents should abide by the terms and conditions that are mentioned in the LC
Documents also need to be shown at a definite place
A letter of credit – How does it work?
Due to the fact that a letter of credit is more of a negotiable payment mechanism, the issuing bank has to pay the beneficiary bank or the bank that has been mentioned by the beneficiary. In case the LC is transferable, the beneficiary might appoint yet another person, third party or corporate parent as an entity that has the right to draw the amount.
As already mentioned above, banks will need a pledge of cash or securities as collateral for issuing a letter of credit. A percentage of the size of the LC will be collected as a fee for providing the service. There are different kinds of LCs available. Read on to know on them.
Types of Letters of Credit
There are many variations to Letters of Credit and each are suited for a separate situation. Let’s take a look at the main types:
1. Revocable: This letter type can be amended or cancelled by either the issuing bank or the buyer any time without any prior notice. However in the current version of UCP 600, revocable LCs have been removed for transactions that are done under their jurisdiction.
2. Irrevocable: On the other hand, this letter can’t be cancelled or revoked unless the three parties – the buyer, seller and the third party agree to the terms and conditions.
3. Transferrable: If the beneficiary is an intermediary for the actual suppliers of services, the payment has to be transferred to the actual suppliers.
4. Un-transferrable: An un-transferrable letter of credit doesn’t allow any transfer of payments to a third party as in such a case, the beneficiary is the recipient.
5. Confirmed: Here the LC will be given a ‘confirmed’ status as the bank that confirms the exporters has added the liability to the issuing bank. The liability will be either assurance of payment or guarantee of payment.
6. Unconfirmed: This letter of credit is guaranteed by the bank issuing the letter and this implies that there’s no sort of confirmation from the advisory bank of the exporter. However, in areas of sluggish economy or uncertainty in political conditions, payments could be at risk in such cases.
The letters of credit are therefore used as a tool to diminish the risk that has substantially grown over the last decade. The letters of credit serve various purposes that are perfect for different functions. The credit professional, on receiving the LC, should review all items to insure what’s expected from the seller and understand all terms and conditions.
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